By David Henry and Rick Rothacker
(Reuters) - Bank executives face great expectations from investors when they report first-quarter results beginning Friday.
Bank stocks have shot up 24 percent this year, as measured by the KBW Banks index, in their steepest ascent in any quarter since the end of September 2009.
Now investors want to know if they should stick with their bets that the economy will strengthen and lift bank lending margins and profits, or take their gains and get out.
"Investors are out on a limb," said Jack Ablin, chief investment officer at Harris Private Bank.
They won't get much help from the earnings, which are expected to be murky this quarter and confused by accounting items. Investors may have to rely on their own hunches to sort conflicting numbers and comments from bank executives about the unfolding course of the economy.
Chris Bingaman, a portfolio manager at Diamond Hill Capital Management in Columbus, Ohio, is among the buyers. Bingaman, whose firm manages $9 billion, said he's been picking up shares of Wells Fargo & Co, JPMorgan Chase & Co, U.S. Bancorp and PNC Financial Services Group Inc lately. The prices, compared with expected future cash flows, are still attractive, he explained.
Still, Bingaman called the banks "revenue challenged" because bank customers remain reluctant to borrow and profit margins are being held down by low interest rates. "That puts a damper on revenue growth overall," Bingaman said.
At the least, Bingaman said, he wants to see the banks report that their lending margins have stopped contracting. Net interest margins at JPMorgan, for example, were down to 2.70 percentage points in the fourth quarter of 2011 from 2.88 points a year earlier and 3.33 points in 2009.
Even if the contraction were to stop, at least another three to six months must pass before lending margins actually increase, said Chris Kotowski, an analyst at Oppenheimer. "You need to see more loan growth," he said.
But Kotowski said that the current slow growth in loan portfolios is a big step from the shrinkage two years ago and points toward increasing momentum in borrowing and a stronger recovery in bank profits. "Slowly, but surely, people are going to realize that this is for real," Kotowski said.
In the meantime, sorting out what is real could be difficult. Some banks will likely report loan growth that stems not from new demand from customers for funds, but from taking business from competitors, said analyst Paul Miller of FBR Capital Markets & Co.
"The overall economic growth needed for loan growth still is not there," Miller said. Loan balances at banks in recent weeks have been running about 4.0 percent higher than a year earlier, according to Federal Reserve data, but some of that increase is thought to have come at the expense of European banks and lenders in the capital markets.
JPMorgan and Wells Fargo kick off bank earnings Friday morning. For 81 financial companies in the S&P 500 stock index, first-quarter earnings are expected to be up 6.5 percent from a year ago, according to surveys of analysts by Thomson Reuters I/B/E/S through April 4. For the full year, analysts expect the earnings will be up 22.4 percent from 2011.
Underneath the averages are likely to be confusing cross-currents about whether the quarter was good or bad. For example, while profits are expected to be higher for banks in general, earnings per share will be down in the first quarter from a year earlier for JPMorgan and Citigroup Inc, according to surveys of analysts.
But compared with the fourth quarter, profits for JPMorgan and Citigroup are expected to be higher. The big reason for the expected flip-flop in fortunes for the two banks: Their trading and investment banking business in the first quarter were worse than a year before but better then three months ago.
Profit from making new mortgages is expected to counterbalance the loss of fee income from new restrictions on how much banks can charge merchants for debit card transactions.
Wells Fargo and JPMorgan have big mortgage operations and some regional banks, such as SunTrust Banks Inc and Fifth Third Bancorp could get a lift, too. Though most new mortgages are used now to refinance existing loans, they are generating additional revenue for the banks.
"We're going to see decent earnings for banks that embrace mortgage banking," said Miller of FBR Capital Markets & Co. "It's probably some of the most profitable stuff you can do."
With overall revenue weak, bankers know investors will be looking hard at their expenses. At Bank of America Corp, whose shares are up 66 percent this year, more than any other big bank, executives are expected to supplement their April 19 earnings report with details of the second phase of a campaign that has already set out to eliminate $5 billion in annual expenses and 30,000 jobs.
Analysts caution that there are at least two wild cards that could rock the results of the biggest banks: trading revenue and the impact of accounting adjustments, known as debt valuation adjustment or DVA, which must be made for changes in the value of debts the banks owe.
Bond trading increased as investors were more willing to take on risk in the quarter than they were at the end of the year. But profit margins for the dealers tightened.
Overall, quarterly revenue from fixed income, currency and commodity trading at the investment banks was likely down more than 20 percent from a year earlier, but up more than 100 percent from three months earlier, analyst David Konrad of Keefe, Bruyette & Woods wrote in a report April 2.
Equity capital markets volumes and fees for advising completed takeovers were down about 25 percent in the quarter from a year earlier, according to Thomson Reuters data.
The accounting adjustments known as DVA perversely reduce the reported earnings of banks when their creditworthiness improves. Because analysts vary in how much work they do to factor DVA into their earnings estimates, the adjustments can create confusion about whether banks actually missed or beat Wall Street expectations.
Bank stock buyers may chose to ignore the accounting noise and the mixed signals. "The psychology seems to be getting better," said Frank Barkocy, director of research at Mendon Capital Advisors. "We're continuing to see signs of improvement in the US economy."
(Reporting by David Henry in New York and Rick Rothacker in Charlotte, North Carolina. Editing by Alwyn Scott.)